What’s so Junk about Junk Bonds?
What are junk bonds? How do I analyze junk bonds? Should I invest in junk bonds? In this post I will explain these questions and tie it all together with a recent real world example.
What are junk bonds?
Junk bonds can be confusing because they go by many names: junk bonds, speculative bonds, and high yield bonds (I’ll interchange high yield bonds and junk bonds for the rest of the post, just remember they mean the same thing). Whatever name you use, these bonds carry credit risk and are classified below investment grade bonds. Does this make them bad investments? Like all investments, the answer to this question depends on the risk/return relationship.
Riskier bonds should pay you higher returns. But never forget the quote from Raymond DeVoe, Jr., “More money has been lost reaching for yield than at the point of a gun.”
Let’s start with the basics. The chart below shows the way the three largest credit rating agencies classify bonds.
Junk bonds are a large asset class ranging from “Non Investment Grade Speculative” to “In Default”. This can be intimidating to investors. How do you analyze such a complex asset class?
How to analyze junk bonds?
Below is a model illustrating a VERY basic framework for analyzing the high yield bond market. This analysis breaks down the asset class into a couple assumptions that can help you think about what currently is happening in the economy and whether the risk/reward trade off is worthwhile. Feel free to download the Excel document for putting in your own assumptions.
Helpful definitions to the model above.
- Default Rate: The rate of borrowers who fail to pay interest or repay principal on their loans. In the base case above, 3.9% of loans are in default.
- Recovery Rate: The recovery rate is the rate of principal and interest recovered on a defaulted loan. In the base case above, 30% of the total defaulted loan can be recovered through likely sources of collateral.
Should I invest in junk bonds?
Why should you invest in anything? To earn a return on your capital of course! More specifically though, junk bonds have been offering higher returns recently, but for higher risks. So lets walk through this risk and return relationship. The chart below illustrates the current junk bond market return rate minus the Treasury rate. This difference is referred to as the spread.
The name of the game is to invest money in junk bonds at the top of the spread, because you’ll lock in those very high yields. Easier said than done though. Whenever spreads spike, there is usually pretty bad economic data within the economy. This leads to increases in defaults (one of the assumptions in our model above). Moreover, spiking spreads have predicted ten of the last five actual recessions (reread that statement and you’ll find it funny).
A recent example
Last year we experienced an increase in high yield spreads. This was accompanied by a heightened fear in defaults within the oil and gas industry. The chart below shows an interesting story when you remove the high yield energy market from the total high yield market. The blue line (high yield energy) drastically spikes compared to the gray line (high yield ex-energy & metals) during the end of 2015 and into the beginning of 2016. Ever so slightly, the gray line creeps up along with the blue line during the end of 2015 and into the beginning of 2016.
We all have seen the price of commodities go through the basement. You don’t have to be a financial analyst to say that some commodity companies might have a hard time paying their debts back with these low commodity prices. However, the interesting story of the chart above is the increase in spreads of the high yield ex-energy and metals sectors. Wouldn’t lower commodity prices be a net benefit for non-commodity companies, as most companies use oil as an input cost to produce other products or services? Here is where the debates start and analysts start drawing lines in the sand. There are many points of view on whether the US economy and the world economy are slipping into a recession or not. Regardless of opinions around the constant recession debate, high yield spreads are currently higher than average, and investors must ask themselves if the spread is attractive enough to invest.
Hopefully, this post gave you a definition of what high yield bonds are AND a recent example of how these investments move around. Let us know if you have any specific questions in the comments.